Dr Chan: Watch The Fed Bears Closely

On 26 September 2018, US Federal Reserve hiked federal fund rate again by another 25 basis points to 2.25 percent. As the news was largely within expectation, investors’ initial response to the hike was largely muted.

However, into the month of October, US investors grew increasingly worried about a more aggressive pace of interest rate hike. On 3 October 2018, after peaking at a record level of 26,952 points, the Dow Jones Industrial Average turned south by 124 points. On the following day of 4 October 2018, the Dow again shed 201 points. In a matter of two days, the Dow corrected 325 points.

Market watchers are anticipating another round of hike in December 2018 and further hikes in 2019. For his role, Fed Chairman Jerome Powell was heavily criticised for pushing for a faster pace of interest rate hike which risks upending the US ageing bull market.

On 10 October 2018, a stock rout erupted in the US market. Asian markets were not spared as bloodletting knocked on Singapore, Hong Kong and China on the following day. Despite the US market continuing to drift lower, the Hong Kong stock market tried to stage a rally on 12 October 2018. In a choppy session, the Hang Seng Index opened higher but plunged into the red in mid-session. It managed to recover and closed slightly in the green. However, before the global market could stabilise, another round of selling began on 15 October 2018. The investment climate grew even gloomier.

In the meantime, the US 10-year treasury yield spiked to 3.2 percent on 4 October 2018, the highest level seen in seven years. In simpler words, what this meant is that investors expect the long-term US interest rate to fluctuate around 3.2 percent for the next 10 years. As US treasury bonds are internationally recognised as primarily risk-free assets backed by the US government, other risky assets such as corporate bonds and equities need to achieve a higher rate of return to attract investors.

For other fixed-rate instruments like corporate bonds, this also meant that bond prices need to fall for bond yields to rise. Other marketable securities such as real estate investment trusts (REITs), utility stocks and other forms of interest-bearing instruments should also see their prices fall. This was indeed the case as witnessed amongst Singapore and Hong Kong utility stocks and REITs and other income stocks.

Apart from the hawkish interest rate outlook, trade war concerns are also weighing heavily on the back of investors’ mind. Trade tensions once again began to simmer when US President Trump and Vice President Mike Pence raised the ante against China. Just recently, Trump had threatened to impose tariffs on all of China’s imports to the US while Pence launched a public attack on predatory trade, coercion and military aggression. The US government also warned China against currency manipulation. Slowly but surely, it would dawn on US investors that a protracted trade war with China would also impact the US economy in the long term.

Responding to the Fed’s hawkishness, Trump recently blasted the Fed for “running wild” and called the central bank his “greatest threat”. Theoretically, the US President could still fire Jerome Powell or any of the Fed’s board members with cause. However, in reality, things are much more complicated as such a move would signal to the world that the US central bank is no longer an independent institution. What could unfold would likely be a catastrophic market rout resembling that in 1987.

Investors should not underestimate where Trump draws the line though. Without pressure from the mid-term election in the coming month of November, Trump could very well have acted without any restraint. On the other hand, Trump’s public condemnation could spur the central bank to raise interest rates even more as a way to preserve its independence. It is therefore highly likely that we see the Fed raise interest rates again in December and 2019.

In the past, the US central bank tend to cut interest rates during the third year of a presidency. This would help to keep the economy healthy moving into the fourth year, which is the election year. As such, if the Fed pushed interest rates higher, Trump would view it as an act of defiance and he could break with traditions by firing Powell whom he personally nominated.

As the Fed has dropped its “accommodative” language, defensive stocks that generally performed well in 1H18 also began to lose their attractiveness. Initially, investors thought that the pace of interest rate hikes was still within expectations. Investors also rotated into defensive counters to protect their portfolio against trade uncertainties.

However, investors have forgotten the original premise of income stocks is to collect dividends. The price action took over and speculation led to valuations being driven to frothy levels. It became apparent that a number of these speculators were seeking to make some quick money and had no intention to hold those stocks.

At first sight that prices are going to come off the cliff, speculators would quickly dump their positions to lock in profits. In such circumstances, selling momentum builds up quickly and it could precipitate into a downward spiral for stock prices.

On the other hand, for long-term investors, higher stock prices inherently mean lower dividend yields. However, in order for dividend stocks to attract investors, dividend yields need to be more than the current US 10-year Treasury bond yield of 3.15 percent. As a result, the mismatch between the expectations of short-term speculators and long-term investors ultimately meant that a correction was bound to occur.

In the short-term, ideal defensive play could be oil and gas related-stocks. This is because investors can ride on the cyclical recovery of oil prices. Higher oil prices typically dictate higher volume of exploration and production activities. For investors’ consideration, there are a few upstream offshore producers listed over in Hong Kong and China. Locally, there are also a few quality oil and gas equipment manufacturers.